1. Technical Field
The present invention relates to a business method for implementing an exchange of service contracts.
2. Description of Related Art
A futures contract is an agreement to buy or sell in the future a specific quantity of a commodity at a specific price. Most futures contracts contemplate that actual delivery of the commodity can take place to fulfill the contract. However, some futures contracts require cash settlement in lieu of delivery and most contracts are liquidated before the delivery date. An option on a commodity futures contract gives the buyer of the option the right to convert the option into a futures contract. Futures and options must be executed on a commodity exchange—with very limited exceptions—and through persons and firms who are registered with the Commodity Futures Trading Commission (CFTC).
Commodity futures or “futures contracts” are highly regulated and generally traded only on the floor of a commodity exchange such as the Chicago Board of Trade, the Chicago Mercantile Exchange, the New York Mercantile Exchange, the New York Cotton Exchange, the Kansas City Board of Trade and the Minneapolis Grain Exchange. Most of the participants in the futures markets are commercial or institutional users of the commodities they trade. These users, many of whom are “hedgers,” want the value of their assets to increase and they also want to limit, if possible, any loss in value. Hedgers may use the commodity markets to take a position, which will reduce the risk of financial loss in their assets due to a change in price. Farmers hedge against future price uncertainties. A cotton farmer, for example, will generally sell futures contracts on a large portion of the cotton crop in order to be guaranteed a minimum selling price prior to harvest. Conversely, a cotton mill owner who wants to sell a customer a quantity of cloth for delivery some months in the future, but does not own enough cotton to produce the cloth, could hedge by buying enough futures contracts to cover the forward sale of cloth.
The cotton mill owner now has a price for raw material to which operating and production costs can be added to arrive at a base price for cloth. Quoting such a price before buying the cotton would make him vulnerable to a price rise, but having bought futures in a quantity equivalent to his needs, he has some assurance that a rise in futures prices would lessen the impact of a rise in the cost of the actual cotton.
Here are three examples of how hedging helps the cash market work better:
                1. Hedging stretches the marketing period. A producer does not have to wait until his product is ready to market before selling the product. The futures market permits producers to sell futures contracts to establish the approximate sale price at any time between the time an immature product is established and the time the mature product is ready to market, sometimes four to six months later. The producer can take advantage of good prices even though the product is not mature enough for market.        2. Hedging protects inventory values. A merchandiser with a large, unsold inventory can sell futures contracts that will protect the value of the inventory, even if the price of the commodity drops.        3. Hedging permits forward pricing of products. A manufacturer, for instance, can determine the cost for a product by buying a futures contract on raw products, translate that to a price for a manufactured or finished product, and make forward sales to buyers at firm prices. Having made the forward sales, the manufacturer can use its capital to acquire only as much raw product as may be needed to manufacture the finished products that will fill its orders.        
Other participants are “speculators” who hope to profit from changes in the price of the futures or option contract. Commodity production and marketing involves sizable price risks, and risk represents a cost, which affects the value of a commodity. While there is no way to eliminate uncertainty, futures markets provide a competitive way for commodity producers, merchandisers, processors, and others who may own the actual commodity to transfer some price risk to speculators who will willingly assume such risk in hopes of making a profit. Take the example of the cotton farmer mentioned above, there the cotton farmer transfers the price risks to a speculator. However, a cotton farmer who sells most but not all futures contracts for a prospective cotton harvest is both a speculator and a hedger because the farmer speculates on the futures contracts being held while hedging on the futures contracts which are sold.
Futures exchanges perform a vital role in a market economy. Because of their highly competitive nature, futures exchanges provide three important economic benefits:                1. With many potential buyers and sellers competing freely, futures trading is a very efficient means of determining the price level for a commodity. This is commonly referred to as price discovery;        2. Futures markets permit producers, processors, and users of commodities, debt instruments, and currency markets a means of passing the price risks inherent in their businesses to traders who are willing to assume these risks. In other words, commercial users of the markets can hedge, which is, to enter into an equal and opposite transaction in order to reduce the risk of financial loss due to a change in price and, by doing so, lower their costs of doing business. This results in a more efficient marketing system and, ultimately, lower costs for consumers; and        3. Since futures markets are national or worldwide in scope, they act as a focal point for the collection and dissemination of statistics and vital market information.        
In the days before credit was readily accessible, some stores carried the sign, “cash and carry,” meaning: pay your cash and carry away the merchandise you purchased. That, in its simplest form, is the cash market. The buyer finds the precise commodity that suits him—perhaps an orange that has ripened to the proper degree—pays his money and becomes the owner of the merchandise. Technically, cash market trading usually occurs after a predetermined point in the life of a commodity future, for instance, forty-eight hours prior to the delivery date. At that point the futures contract leaves the futures market and automatically converts to a cash contract.
Sometimes, cash markets can be modified and improved to serve a particular purpose. For example, a person who goes to the newsstand to buy a magazine may find that it is more convenient to contract with the publisher for delivery at home. This modification is called a forward contract, and such contracts are widely used in many types of business. The buyer and the seller agree today on a description of the product that will be delivered in satisfaction of the contract. The buyer makes payments as agreed, and the seller will deliver the asset at a designated site on a specified date. The problem with this arrangement is that the buyer cannot take adage of price reductions due to supply and demand pressures.
Futures contracts differ from forward contracts in that the owner of a futures contract may sell any part of the contract prior to the contract being executed. An owner of a forward contract must take possession of the physical commodity without transferring any right or portion of the physical commodity prior to execution of the forward contract. Conversely, the owner of a futures contract may sell the contract prior to the date of execution or even sell options on the contract that may act to leverage the futures contract away from the owner in the future.
In a competitive market system, buyers and sellers determine prices for commodities through their transactions in the marketplace. The prices at which sellers offer to sell their goods and buyers bid to buy them are based on their best current assessments of the supply and demand for the commodity.
Usually, no one knows the exact total supply of a commodity. For example, in the United States most commodities are produced by many firms. Storage and ownership are also fragmented. The total supply available is usually an estimate, as is new production, and inventory figures are not precise. In addition, the quality of the commodity frequently is not known. Thus, contributing to the complexity of determining an appropriate price.
Demand is even more difficult to measure, based as it is on what people may decide they wish to buy. Changing prices may alter consumers' intentions regarding the quantity of a close substitute commodity they want—or whether they want it at all. The availability of a substitute may change the demand picture for the original product as well as for the related one. However, prices for goods in the marketplace play a vital role in our economic system and help to efficiently allocate scarce resources.
Price is a rationer; if the price is right, the supply of a commodity should balance the demand for it—production should match use. If the price is too high, some who may have planned to use a product may decide to use less, go without, or they may select a substitute for example, they may eat chicken instead of beef. If enough users are priced out of the market, the price may turn down which may encourage more use and discourage production. If the price is too low, users will deplete existing supply and a shortage may develop. Subsequently, prices may rise, which will tend to discourage marginal buying. Should the price remain relatively high this would likely promote production or attract additional supply of the good.
Price discovery is the process of arriving at a figure at which one person will buy and another will sell a futures contract for a specific expiration date. In an active futures market, the process of price discovery continues from the market's opening until its close. Futures markets, because of low transaction costs and frequent trading, encourage wide participation, lessening the opportunity for control by a few buyers and sellers. Because they are freely and competitively determined, futures prices are generally considered to be superior to administered prices or prices that are determined privately.
Price discovery for a particular commodity usually occurs between a buyer and a seller of a particular commodity on the floor of a futures exchange. The floor area of an exchange is divided into pit areas or pits for trading of a particular commodity, e.g. corn, wheat, and cattle. Buyers and sellers of commodities negotiate a price or discover a price in the pit. The trading process is an extremely fast-paced interaction between licensed brokers who use hand signals to communicate a price and acceptance to one another. Once a bid price and an ask price match the contract price is agreed and price discovery occurs. Futures contracts are usually standardized as to quantity, quality, and location so buyers and sellers in the pit only bargain over price. Because of this standardization, commercial interests are better able to compute local cash prices. This contributes to local market efficiency and to consistency among markets. In many commodities, futures prices have earned a role as key reference prices for those who produce, process, and merchandise the commodity. Since cash and futures prices reflect similar price-affecting factors, their price levels tend to rise or fall together.
Forward prices resulting from forward contracts, on the other hand, are preset at a predetermined price level and many times that price is quite different from the cash price for a commodity. Because the owner of a forward commodity contract cannot participate. in a futures market, the forward contract is exempt from the price discovery process. Therefore, forward prices reflect a certain inefficiency brought about by inaccurate assessments of future supply and demand for a commodity. The difference between the forward price and the cash price is referred to as the price basis or basis. The magnitude of the basis is a measure of the inefficiency inherent in the particular forward market.
Futures trading is not intended as a way to transfer ownership of the actual commodity, so few traders deliver on futures contracts. Cash markets normally provide the most efficient way to exchange ownership of a commodity; futures markets are a way to forward price the commodity and to lessen the risk of ownership. Studies have concluded that the futures markets do not “cause” cash market prices to rise or fall. Both the cash and futures markets respond to the same basic supply and demand factors. Because futures trading has low transaction costs, participants are able to actively and immediately express their views on their estimate of projected likely prices. New information is continuously injected into the market via last sale prices for various futures contracts. This results in expectations about price movements being first noticed in the organized exchange traded futures markets. On the other hand, the cash market tends to respond to situations in its local geographic area while the futures market tends to additionally consider broader national, as well as international implications to events. But the regulatory force of arbitrage—which is the simultaneous purchase and sale of identical goods in two markets at different prices to capture a riskless profit—keeps all markets in rough balance. Either price may move first or furthest.
Forward contracts, on the other hand, represent only a price snap shot in time. Unlike a futures contract, the owner of a forward contract will take delivery of the commodity on a predetermined date. Forward contracts are often negotiated between an institutional seller and a buyer, where the buyer is either the end consumer or a smaller commercial buyer. Once a match occurs between the buyer and seller on a forward contract, that commodity contract is no longer traded in the commodity exchange. Because of the nontransferable nature of forward contracts, their use in commodity markets is somewhat limited. The price discovery process is interrupted.
Forward contracts are, however, the primary mechanism for contracting for future services. Generally, an institutional service seller is the service producer itself and the buyer is the consumer of the service. The basis for most services often are extremely high, that is, the cash price is several times higher than the forward price. The cash price for a sporting or entertainment event will often cost twice the forward price. Normally the patron will order tickets over the telephone or Internet and pay by credit card. The buyer receives a confirmation number or optionally an E-ticket that may be printed from his home computer . At the agreed time and delivery point the buyer presents the confirmation number to the service provider/seller. Usually, the seller controls a box office at the venue and the buyer is admitted.
The same supply and demand pressures that cause commodity prices to fluctuate also affect service prices. The seller attempts to determine an optimum price level for the forward contracts. An optimum pricing strategy might be to adjust the forward contract ask price equal the cost of the service for the seller such that all cash contracts (tickets sold at the door) would represent pure profit to the seller. In that way the seller is hedging with the forward contracts and speculating with the cash contracts. This pricing strategy usually requires that the seller set the forward contract price somewhat lower than the right price for the service in order to guarantee that the event will break even. If the seller raises the forward contract price too high, patrons will seek out alternative entertainment for that date. Alternatively, if the forward contract price is set too low, buyers may gobble up all the forward contracts and the seller may have to rely on the cash contracts for both costs and profit. However, because the forward contracts sold are non-transferable, the seller can be assured that a certain number of the forward contracts will not be redeemed. The seller may either oversell the forward contracts (overbooking), sell additional cash contract for the unredeemed forward contracts, or some combination of both. It is apparent from the forgoing that no price discovery mechanism exists in a service market and the right price for services is never discovered.
It would be advantageous to provide buyers and sellers of a service with a mechanism for discovering the right price for a service.